Remarks at FINRA Enforcement Conference

Commissioner Daniel M. Gallagher

Alexandria, VA

Nov. 7, 2013

Thank you, Brad [Bennett], for that kind introduction, and good afternoon to all of you. Last year, I went out to a conference center in North Bethesda to give what I thought were to be informal remarks to a small group of about 20 of your FINRA Market Reg colleagues. When I showed up, I found a room with a stage, a podium, a microphone, and a couple of hundred Market Reg personnel expecting a formal speech. So when I was told that there would be about 240 of you here today, I thought I should go ahead and prepare myself for a cast of thousands…. This is something of a letdown.

In all seriousness, I’m delighted to be here with you all today and to have an opportunity to address the subject of enforcing the securities laws, a topic in which we share a deep interest. As I’m sure you know, we’ve had quite a bit of turnover on the Commission in the last year, with our new Chair, Mary Jo White, arriving in April and our newest Commissioners, Kara Stein and Mike Piwowar, arriving in August. And, of course, there has been substantial turnover amongst the senior staff. Whenever new people come to the SEC, whether it’s a new Chairman, a new Commissioner, or a new member of the staff, they always seem to find odd things about the SEC that puzzle them, leading them to ask perfectly reasonable questions. In many cases, these are things that seasoned observers of the SEC take for granted and just don’t think about anymore. For example, a lot of newcomers to the agency ask why one of our primary enforcement remedies is to tell someone who’s just broken the law, “Hey – don’t break the law again.” In some cases, we might have to do it a second time, and we end up saying, “Hey – don’t break the law again – and this time we really mean it.”

The funny thing is, these newcomer questions, while basic, are almost always tremendously relevant. Trying to answer those questions often requires us to go back to first principles, or to look at the text of our enabling statutes, or even to revisit the agency’s history, and those are all good things for us to do periodically. So I say, why let the newcomers have all the fun? I think you and I have just as much right to ask tough, foundational questions as the rookies do, and I think now’s as good a time to start as any. So let me pose one of those questions right now: Why does the SEC have an enforcement division?

You might think that the answer to that is, well, of course a regulatory agency should have an enforcement division. Someone has to enforce the relevant statutes and regulations, or else no one would respect the laws. But in fact, having an in-house enforcement division is the exception rather than the rule for federal agencies. Most agencies do not have the authority to enforce their own regulations and the statutes under which they are promulgated through litigation in federal court. Under the U.S. Code, federal agencies must rely on the Department of Justice (“DOJ”) to conduct their litigation except – and this is the important part for our purposes – as otherwise authorized by law.[1] Thus, the default rule is that DOJ litigates for government agencies, unless Congress has specifically determined otherwise.

As it turns out, Congress did determine otherwise in the case of the securities laws. As originally passed, the Securities Act of 1933[2] authorized the Federal Trade Commission to seek injunctions in federal court concerning violations of that statute. A year later, Congress transferred this enforcement function to the newly created SEC in the Securities Exchange Act of 1934.[3] And it didn’t take long for someone to challenge this grant of independent litigating authority.

In 1935, in a case called SEC v Collier,[4] the Second Circuit confronted and decided a single question: whether the SEC may bring its own enforcement action under the ’33 Act, or whether it must rely on the Attorney General to do so.[5] The appellate panel that heard this case was composed of superstar judges: Learned Hand, Thomas Swan, and Augustus Hand (Learned’s older cousin). The court, in an opinion authored by Judge Learned Hand, found unanimously in favor of the Commission, upholding the suit brought by Commission staff.

Of particular interest to us today is a footnote in the case – in fact, the only footnote in the case – quoting the testimony of Robert E. Healey, the chief counsel of the Federal Trade Commission, during the legislative hearings preceding passage of the ’33 Act. Healey stated that the Senate bill, as initially drafted, directed the FTC to refer evidence of offering fraud to the Attorney General. The Attorney General would have been responsible both for stopping the fraud by means of an injunctive action and for punishing the guilty parties by means of a criminal action.[6] Healey suggested a different approach, stating: “Congress by this bill should say to the Attorney General, ‘Punish them,” and then say to the Federal Trade Commission, ‘Stop them.’ I would amend this bill to provide for giving the power to apply for injunctions to the Commission.”[7] Referring to the Attorney General, Healey said “Let him prosecute criminally, let us proceed to stop them.”[8] After the legislative hearings, the language of the bill was amended to adopt the enforcement model suggested by Healey, giving the FTC the power to bring injunctive actions independently. Two years later, the Collier court established that the ’33 Act indeed conferred independent litigating authority on the FTC and, subsequently, the SEC.

And so we have made some progress towards answering the question of why the SEC has an independent enforcement function, as well as the question of why one of the agency’s primary remedies is the injunction. At the birth of the securities laws, Congress intended for the FTC – and soon afterwards, the SEC – to stop ongoing violations of the securities laws, including ongoing frauds. Punishment was not the Commission’s primary enforcement mission; rather, that mission belonged to the Department of Justice. The Commission’s original enforcement mission was to stop ongoing violations and to prevent further harm to investors and the markets.

Over time, the nature of the Commission’s enforcement authority has, of course, evolved. For much of the twentieth century, with limited exceptions, the Commission lacked civil penalty authority against either individuals or corporations; the agency was limited to seeking injunctions and other equitable remedies, such as disgorgement and officer-and-director bars.[9] In 1984, Congress passed a law giving the Commission authority to seek civil penalties in insider trading cases,[10] and this authority was enhanced substantially by passage of another insider trading law in 1988 that followed the Boesky/Milken scandal.[11] The passage of the Remedies Act in 1990[12] was another watershed, giving the Commission, among other things, robust penalty authority against individuals and nuanced penalty authority, to be used judiciously, against corporate issuers. Throughout this period, the enforcement staff of the Commission was intermittently reorganized until a major restructuring in 1972 established what we now know as the Division of Enforcement.[13]

As the Division was granted new and more powerful enforcement tools, it developed a highly respected remedial program that effectively complemented the Commission’s regulatory programs. Indeed, one of the major advantages of a federal agency having its own enforcement arm is the presence of a dedicated body of staff who are willing and able to support the Commission’s regulatory programs and policies. Can you imagine the reaction we would get from the Department of Justice – especially now – if we were required to go to them every time we wanted to bring an enforcement action for a books-and-records case or a net capital violation? I imagine they would respectfully tell us that they have other priorities, and rightfully so, from their perspective. But from our perspective, bringing actions for such rule violations is crucial to the success of the Commission’s regulatory program, and that program is itself crucial to the SEC’s tripartite mission: the protection of investors, the facilitation of capital formation, and the maintenance of fair, orderly, and efficient markets.

And here we return to the question I posed earlier. In the modern era, what is the current purpose of the SEC’s enforcement division? Many people, including senior SEC officials, have answered that the SEC needs to be the cop on the beat, and to be a tough cop to boot. And there is an impulse by the stewards of the SEC enforcement program to prove that their program is tougher than those preceding it. But the reality is that, no matter what resources we get from Congress, we’ll never be able to put an enforcement attorney on every corner. So this “cops on the beat” analogy can set us up for failure. For example, an excessive focus on fraud cases in an effort to demonstrate toughness can carry with it serious unintended consequences and can actually misconstrue the Division’s mission. If all the Division did was to bring fraud cases, then it wouldn’t be adding any value beyond what the Department of Justice could do, in which case one could argue that we should just transfer that staff and their allocated budget to the civil and criminal fraud programs at DOJ. There would be no need for us to have our own enforcement division.

What the Commission must do to in order to be effective is to leverage whatever resources we’re given in a meaningful way, and that means using enforcement resources to complement our mission-critical efforts on the regulatory side of the ledger. The purpose of SEC rules is to regulate markets and market participants so that the securities markets are honest and effective, so much so that they earn the confidence of investors and other market participants. But our rules will only effectuate that purpose if they’re complied with, and for that, we need the Division to bring cases for regulatory violations that vindicate our rules. In fact, putting aside the often over-used just and equitable rule, this is precisely the model under which FINRA’s enforcement staff operates. Your work serves to vindicate the rules in the FINRA rulebook and to give force to the policies underlying those rules. In doing so, you help carry out our shared commitment to upholding and enforcing the federal securities laws.

By passing legislation that pervasively regulates the securities markets and market participants, Congress recognized the special roles played by broker-dealers, investment companies, investment advisers, registered clearing agencies, municipal securities dealers, municipal advisers, transfer agents, and so on. The SEC exists to oversee these firms and their employees, and the Division of Enforcement exists to support that mission. Disconnecting the Enforcement Division from the regulatory divisions – by effectively turning it into an annex to the Justice Department – eats away at Enforcement’s raison d’etre.

Thinking of the Enforcement Division as merely a tough cop searching for fraud reflects an overly simplistic view of the highly nuanced and technical nature of the Commission’s jurisdiction. The SEC’s Enforcement Division doesn’t always deal with easy, black-and-white questions of right and wrong. In most cases, the staff is required to make judgments that reflect the subtlety of the Commission’s regulatory program and policy objectives. That’s a lot harder than solely seeking to punish securities fraud, but it’s every bit as vital, and – more importantly – Congress intended for the Commission’s enforcement staff to play that complex, challenging, and specialized role.

In my view, the Division of Enforcement shouldn’t be viewed – and certainly shouldn’t view itself - as a separate and independent entity from the rest of the Commission. Rather, the enforcement staff should, and indeed I believe most do, view themselves as equal partners with the regulatory staff, sharing a common mission. Such a mindset fully accords with Congress’s vision for the SEC and its staff, while still giving full recognition to the special role that Enforcement has to watch over the SEC’s registrants and markets.

The SEC is a capital markets regulator, and its enforcement function should support its efforts to maintain and improve our capital markets. When cases requiring criminal punishment arise, we should be happy to loop in our counterparts at DOJ and assist them in bringing meaningful criminal actions. And we should bring meaningful civil fraud cases – particularly scienter-based fraud cases – against both entities and individuals when circumstances require it. But we cannot forget to tend to our regulatory programs, and we should take every opportunity to bring regulatory cases for violations of even the most technical rules.

So how do we get there from here? Well, I take heart from recent comments made by Chair White about the importance of ensuring that we pursue not only the biggest frauds, but also “violations such as control failures,… and even violations of prophylactic rules.”[14] And there are some recent cases that also give me cause for optimism. In September, the Commission brought a series of enforcement actions against a large number of respondents for violations of Rule 105 of Regulation M, which prohibits covering short sale positions by buying shares in a public offering.[15] These are real cases, and they operated to support an important rule that is designed to protect the integrity of public offerings and to protect investors purchasing securities in such offerings. Also, back in July, the Commission brought a case in the insider trading context against the manager of a large hedge fund, charging him with the failure to supervise certain employees and prevent them from insider trading while under his supervision.[16] And that case followed closely on the heels of the CFTC’s enforcement action in the MF Global case, in which the CFTC charged the former CEO of that firm on the basis of control person and failure-to-supervise theories.[17]

These types of enforcement actions are very much in our wheelhouse. In fact, we periodically see SEC cases that fit quite neatly into the above pattern or at least a reasonable facsimile thereof. However, in some of those cases, usually settlements, the staff elects to pursue, and a majority of the Commission elects to approve, weak, non-scienter fraud charges against the entity rather than a cleaner regulatory violation against both the entity and the culpable individuals. In certain cases, not involving actions against individuals, the Commission has been asked to impute liability to the entity on an untried “collective negligence” theory rather than on an established legal theory like respondeat superior.

What I have noticed in these enforcement actions is that, in many instances, they were weak fraud cases, but would have made excellent failure-to-supervise cases, just like the ones I described a moment ago. I would much rather see the staff bring high-quality failure-to-supervise cases than to try to shoehorn bad facts into a weak fraud theory. A failure-to-supervise theory often provides an elegant solution to factual and legal difficulties posed by a questionable fraud charge, particularly a non-scienter fraud charge based on some ethereal notion of “collective negligence.” And bringing a failure-to-supervise case would also vindicate SEC regulations that serve an important role in regulating the securities markets. In my mind, that’s two for the price of one.

While we’re on the topic of failure-to-supervise, I’d like to be very clear that the Commission and FINRA should be very cautious about bringing failure-to-supervise cases against chief compliance officers, general counsels, or their subordinates. In our regulatory regime, these compliance and legal personnel play significant day-to-day roles in implementing compliance systems at regulated firms, both in terms of preventing legal violations and also in terms of dealing with the aftermath of violations that do occur. We should be encouraging these personnel to run towards problems, not away from them, and we should not threaten them with liability for trying to be part of the solution. Neither the Commission nor FINRA should lightly seek to charge CCOs, GCs, or their subordinates with failure-to-supervise violations. In that vein, I was very pleased to see the SEC’s Division of Trading and Markets recently issue important FAQs in this space, and I commend them to you. In fact, I think it would be terrific if FINRA provided parallel guidance in this area with its own FAQs, or perhaps even a formal guidance document.

Returning to my larger theme, the Commission should spend more time thinking about how better to integrate the Enforcement Division’s work into the Commission’s regulatory mission and policy objectives. More thought should be devoted to areas of the Commission’s regulatory program that have been overlooked and perhaps neglected from an enforcement perspective. The Enforcement Division is and should be much more than just a cop on the beat, tackling random crimes. It could be a “force multiplier” for the Commission’s prophylactic regulations. This would give our regulations greater impact and help effectuate their larger purpose of preventing harm to investors by fostering a healthy, well-regulated securities market. And we can all agree that the SEC’s resources would be far better leveraged if we could prevent harm instead of just cleaning up after all the damage has been done. As Benjamin Franklin famously said, an ounce of prevention is worth a pound of cure.

I’d like to thank you for your attention and for the opportunity to speak with you today. I believe the enforcement work you do at FINRA is critically important, as you are charged with overseeing registrants and protecting the integrity of the marketplace that we jointly regulate. Thank you, and I hope you enjoy the rest of the conference.